Companies raise finance through several sources, the most common of which include equity finance. This finance comes from a company’s investors or shareholders. Usually, equity finance is perpetual, meaning companies keep it until closure. However, this finance source comes with a higher cost due to its long-term nature. In some cases, companies may want to go for a more inexpensive source instead.
Debt finance, which usually includes loans, comes from third parties. This finance source opposes the equity finance and internal finance that companies raise. Usually, debt finance comes through loans from financial institutions. However, these may include financial instruments that companies issue to the market, known as bonds.
One of the most distinguishing features of debt finance is the interest payments associated with it. Most debt finance sources involve a company paying regular interest to the investors or lenders. In some cases, companies may also suffer accrued interest, which is different from regular interest. Before discussing the difference, however, it is crucial to understand what interest constitutes.
What is Interest?
Interest is a charge associated with debt finance, which involves a percentage of the principal amount. This amount is payable by the borrower to the lender based on the loaned amount. Usually, every loan or debt instrument includes an interest rate that dictates how much the borrower must pay. For example, a bond may involve a 5% interest, which will be the interest on its par value.
Interest is a fee that the borrower charges from the lender in exchange for using their funds. In other words, it is the price a lender pays for the privilege to use the borrower’s money. Usually, this amount comes in the form of an interest or coupon rate. This rate dictates how much interest the lender must pay on the loaned amount. In some cases, it may involve a floating rate, which changes based on a base rate.
Interest payments are an expense for the borrower while constituting income for the lender. In most cases, debt instruments include an annual interest rate. However, the amount is also calculatable for a longer or shorter period. Apart from that, there are other types of interest that lenders may charge. Some types are more favorable for the lender, while others may favor the borrower.
Overall, interest is an amount paid on a loan or debt instrument. This amount represents a lender’s obligation to the borrower in exchange for the use of funds or loan. Usually, it is a fixed rate, which both parties specify before the debt contract commences. Calculating interest for loans is straightforward for fixed interest rates. However, a floating rate interest may involve more challenging calculations.
What is Regular Interest?
Regular interest is a payment made as a charge in exchange for borrowing a loan. When a lender borrows an amount from a financial institution, the loan comes with an obligation to pay interest. As mentioned, this interest represents the expense for using the underlying loaned amount. Depending on the party involved, this interest either represents an expense or income.
When a lender loans money from a financial institution, for example, a bank, the borrower requires interest payments. These payments arise from a fixed interest rate, which both parties specify when the contract commences. In some cases, however, this rate may also be floating, based on an index, for example, the Federal Reserve lending rate.
The concept of regular interest is straightforward to grasp. It represents the amount charged by the borrower for a loan provided to a lender based on the specified rate. Usually, it is an annual rate based on which the lender pays the borrower. In most circumstances, the total amount depends on the remaining loan amount that the lender will repay.
For example, a company receives a loan of $100,000 from a borrower for a 10% annual interest rate. Therefore, it must pay an interest payment of $10,000 annually. However, once the company repays a portion of the loan, the interest rate will apply to the residual amount. Assuming it reimburses $20,000 of the loan amount in the next year, this residual amount will be $80,000. Therefore, the annual interest will fall to $8,000.
What is Accrued Interest?
Accrued interest is a term associated with the accruals principle in accounting. It refers to the amount of interest that a borrower incurs at a specific date. However, it does not represent a cash or interest payment. In other words, accrued interest is the charge that a borrower accrues but has not repaid at a specific time. The term accrued interest is crucial for lenders and borrowers.
For borrowers, the term accrued interest represents an expense that it must charge in its accounts. Under the accruals principle in accounting, an entity must record an expense when it incurs it. It does not consider the payment associated with it. Therefore, the borrower must recognize an expense in its accounts when it incurs this interest. In short, accrued interest for the borrower represents an unpaid expense at a specific date.
For the lender, accrued interest represents earned income. However, there is no associated payment attached to it. In other words, it is the income a lender has earned but not received from the borrower at a specific time. Under the same accounting principle, the lender must recognize it as income in its accounts. However, it will also account for the associated receivable with it.
Accrued interest becomes a part of the income statement. However, it also influences the balance sheet due to the associated receivable or payable amount. Any subsequent transactions will affect the balance sheet only. Accrued interest impacts the income statement only once, which is at the time of initial recognition. Usually, this interest follows a payment from the lender to the borrower after an accounting period.
Overall, accrued interest represents any interest expense that a borrower incurs. It does not involve any payments related to it. Under accounting standards and principles, an entity must still recognize this amount in its accounts. Therefore, accounting for accrued interest is crucial. For the lender, this accrued interest represents income for which it has not received cash.
What is the difference between Regular Interest and Accrued Interest?
The primary difference between regular interest and accrued interest is the payment aspect. Regular interest represents an expense that a borrower incurs and for which it pays the lender. Therefore, this interest involves a payment. In practice, however, there may be a delay between both transactions. Hence, the regular interest may become accrued interest.
Accrued interest, on the other hand, does not contain a payment. However, it does not imply the borrower will not repay the amount. Instead, it involves repayment at a later date due to the timing difference on the transaction. The concept of accrued interest falls under the accruals principle in accounting. This principle requires an entity to record expenses when they incur rather than when the payment occurs.
For example, a company receives a $20,000 loan from a lender at 5% annual interest. It pays this interest at the start of the accounting period. Therefore, the company incurs an expense of $1,000 at the end of the accounting period. Under accounting principles, it must record this amount in its books as an expense with a corresponding payable amount. Once it pays for this amount, the company must remove the payable balance.
Conclusion
Interest is a term that represents the charge from a lender to a borrower in exchange for a loan amount. This amount depends on an interest rate, which both parties agree to within the contract. Usually, borrowers incur the interest expense before paying for it. Therefore, this amount represents accrued interest for the borrower. It is different from regular interest, which involves payment at the same time.